Excess capacity is a characteristic of monopolistically competitive firms. What does excess capacity mean?
A) It means that firms do not produce the output level that corresponds to the minimum point on their average total cost curves.
B) It means that firms hire more than the minimum number of workers needed to produce the profit-maximizing level of output.
C) It means that firms produce with inefficient combinations of resources.
D) It means that firms build plants that are not large enough to achieve minimum efficient scale.
The correct answer and explanation is :
Correct Answer: A) It means that firms do not produce the output level that corresponds to the minimum point on their average total cost curves.
Explanation:
Excess capacity in monopolistically competitive firms refers to the situation where firms operate below their optimal production level, meaning they do not produce at the minimum point of their Average Total Cost (ATC) curve. This concept arises because firms in monopolistic competition face downward-sloping demand curves due to product differentiation.
Unlike perfectly competitive firms, which produce at the point where P = MC = ATC (minimum ATC), monopolistically competitive firms set prices above marginal cost (P > MC) and produce at an output level lower than what would minimize average total cost. This happens because:
- Market Power and Product Differentiation:
Since firms in monopolistic competition sell slightly differentiated products, they have some market power, allowing them to charge prices above marginal cost. This also means they do not have to produce at full efficiency. - Inefficiency in the Long Run:
In the long run, new firms enter the market if existing firms are earning profits, reducing demand for individual firms. As a result, each firm faces reduced demand and must operate at a level of output that is below the efficient scale. - Comparison with Perfect Competition:
In perfect competition, firms produce at the minimum ATC, achieving full efficiency. In contrast, monopolistically competitive firms produce less than the efficient output, leading to excess capacity.
Thus, excess capacity is a natural consequence of monopolistic competition and is a sign of inefficiency in resource utilization. While this inefficiency exists, it allows for variety and consumer choice, which can be beneficial to consumers.
Illustration:
Here is the graph illustrating excess capacity in monopolistic competition. It visually represents how firms in this market structure produce at an output level lower than the minimum average total cost, leading to inefficiency.